5.4 Business Valuation - Discounts and Premia

Just because a business has ascertainable value -- because of a predictable earnings stream or marketable assets -- does not mean that the value of investment interests in the business are immediately ascertainable. It is one thing to say that Widget Inc. will generate $100,000 in annual earnings over the next 10 years and quite another that a 1% shareholder of Widget has an interest that is worth $1,000 paid annually for 10 years.

In this section, we first look at the bundle of rights that inhere in ownership interests - particularly common stock in a corporation. We then turn to the deviations from pro rata valuation when an owner has either a controlling interest (control premia) or a non-controlling minority interest (minority discounts). Finally, we consider the effect of illiquidity in valuing an ownership interest (marketability discounts). In many valuations, discounts are the essence of the game.

5.4.1 - Ownership interests - bundle of rights

Business ownership interests carry certain essential rights. The owner has financial rights to a portion of the firm's income stream, governance rights to participate in choosing managers and making business decisions, and liquidity rights to sell or dispose of these rights to others. (More 5.4.1>>)

5.4.2 - Control premia

When a purchaser acquires a 100% interest of a business, included is complete control. The purchase price includes a "control premium". Data suggests that shares with control comand a premium of 30-40% above the value of freely-traded non-control minority interests. (More 5.4.2>>)

5.4.3 - Minority discounts

Financial interests owned by persons lacking control (minority interests) are typically worth significantly less than the pro-rata share of total firm value. In a corporation, noncontrolling shareholders cannot compel the declaration of dividends, the payment of salaries, the carrying out of business plans, or fundamental transactions such as a merger, sale or liquidation of the company. How much should minority shares be discounted? (More 5.4.3>>)

5.4.4 - Marketability discounts

The inability to readily sell a financial interest (whether because of a lack of willing buyers or contractual restrictions) significantly reduces its value. After all, what's so great about the promise of future returns if you need money now? (More 5.4.4>>)

5.4.5 - Other sources of discounts

Discounts may also be appropriate for potential capital gains on C corporation holdings of appreciated assets. (More 5.4.5>>)